Real Estate Partnership- Ordinary vs Portfolio Income

Technical topics regarding tax preparation.
#1
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How's it going everyone? Been lurking for a year or two and have a question I am stumped on. I am a sole practitioner so I have been running in circles in my brain and thought I may try out the board for some assistance.

Background: Client is a Real Estate fund that invests in "Land Banks" and also sees some deals throughout the entire construction process (Land purchase, construction, sale). A Land Bank for those who don't know is essentially the fund acting as the lender for land investments so large home builders can deploy their capital elsewhere. The Land Bank will purchase the land (So titled in my clients LLC) and charge an "Option Fee" on the capital balance outstanding (12 - 15%), the home builder agrees to purchase a certain # of lots each quarter until the land has 100% transferred to the home builder. The land is only held for a year or 2 and lot tracts start being sold within a few months of closing. The actual sale transaction of the lots to the home builder is always a "net zero" sale (proceeds = basis). So the only income in these entities is the option fees.

The Fund has big time investors and over $25M in capital raised. A top 8 firm does the audit and is working on the fund tax return. I connected with a college buddy who is working for the fund and they engaged me to work on some of the land banks. The top 8 firm had already started 1 of the land bank entities so I took 3 others. The Fund sets up separate LLC's for each investment project so each "Land Bank" has a separate tax return. They have a very close strategic partnership with one of the largest home builders in the country and they do most of their deals with them as joint ventures.

Anyways --- I proceed to prepare 2 of my land banks. From the start, I considered all of this income to be ordinary income. 1) Land Banking is by definition the funds trade/business. The income generated from the option contracts is over 75% of their revenue and the fund was created to manage these kind of "land bank" deals. 2) Option Fees are not interest income ---- The Tax Court has held that payments under an option are not taxable as interest, even though they are expressed as a percentage of the purchase price. Moreover, option payments do not lose their nontaxable character merely because they are not to be offset against the purchase price. Carl E. Koch
, 67 T.C. 71 .

Last week, the other firm prepares one of their land banks and proceeds to classify the option fees as Interest Income. Interest/Portfolio Income specifically excludes income derived from dealing in any property if such activity constitutes a trade or business. Is there some kind of exception for real property/land? My contact has not had a chance to ask the appropriate questions to the other firm and I am starting to stress a little so I wanted to ask the board.

My 2 main questions are:

1 - Is there some type of support that would allow the option fees to be treated as portfolio income?

2 - At the fund level (holding entity), is there a benefit to wealthy investors (millions in income per year) to receive "Portfolio Income" over Passive Ordinary Income? I cannot think of any reason but I would assume if the other firm took this position it is more beneficial?

Let me know your thoughts when you get a chance. If I wasn't clear on anything, please ask for clarification. Really appreciate everyone's help, you can only do so much tax research by yourself before you start to go crazy!

Thanks.
 

#2
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Bump please --- I think my post was too long :shock:
 

#3
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the home builder agrees to purchase a certain # of lots each quarter

What are you saying: There is a pre-arranged purchase agreement in place at inception?
 

#4
dave829  
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It sounds like the LLC purchases land, subdivides it into lots, and then sells the lots to home builders for a profit (the option fee). How is this different from any other real estate developer whose business is to acquire land primarily for sale to customers in the ordinary course of business? See Boree, T.C. Memo. 2014-85 (https://www.ustaxcourt.gov/UstcInOp/Opi ... spx?ID=521).
 

#5
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Thanks for the responses guys.

Jeff --- The pre arranged agreement is called a "Lot Purchase and Sale Option Agreement". The agreement details the grant of the options, options rights/fees, and the lot takedown schedule. If the home builder does not close on the lots per the "Takedown" schedule, they are considered to be in default and the Seller can sell the lots elsewhere.

Dave829 ---- The land is already subdivided when the LLC purchases it. So no actual development but yes, still just inventory held for resale in my mind. It is a little different because the land is actually never sold at a gain, the only profits generated are the option fees and the purchaser of all the lots also has a 10% capital interest (pretty much a deposit) in the Land Bank LLC. We are on the same page in thinking it is ordinary course of business, I just cant wrap my head around what would lead the big firm to classify this as interest income instead of ordinary income?
 

#6
Chay  
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I see your facts as distinguishable from those in Koch. In that case, the option fee was paid in exchange of a right to purchase which could be freely exercised or not by the purchasing party. In your case, it sounds like the purchase has been contractually agreed to and the option fee is nonrefundable. If this is so, then I would view the "option fee" in line with all other funds received as proceeds in one or multiple sales transactions.

Under this position, the income would still be ordinary because you're dealing with inventory sales. But apart from possibly changing the manner of reporting the income on Form 1065, this analysis may be useful in considering the other questions you raised. I think it's very difficult to support the position that this type of income should be considered portfolio income because it essentially constitutes an advance payment of all of the gain from the partnership's sales of inventory. If any debt existed, it would be owed by the partnership to the purchasing party in respect of the early cash they received. If we impute interest on that debt, the result would additional income to the buyer and not the seller.

For passive investors, showing the income in box 1 of the K-1 is more advantageous because it would allow them to claim passive losses. For actively-involved partners, portfolio income may be more advantageous as it would allow them to avoid paying self-employment tax.
 

#7
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Bingo. Thanks, Chay.

I have definitely thought it is more advantageous for passive investors to have ordinary income for that reason --- claiming other passive losses. Almost all of the income in the Fund (a limited partnership) will be passive on the investors tax returns. It seems to me the big firm is taking this position of portfolio income because they think it is correct, not because it is a more advantageous position...
 

#8
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It seems to me the big firm is taking this position of portfolio income because they think it is correct

I’m leaning towards that as well, but we want to know why. On the surface, it certainly does seem like it’s a lending arrangement. However, like in Koch, there is no true/labeled/legal indebtedness. The paperwork reveals that truth. But is that factor, the label, determinative?

In that case, the option fee was paid in exchange of a right to purchase which could be freely exercised or not by the purchasing party. In your case, it sounds like the purchase has been contractually agreed to and the option fee is nonrefundable.

As to your second sentence, that’s kind of what I was getting at with my Post #3. But Post #5 seems to reveal that it’s a true option arrangement. But if it really is a “contractually agreed to” purchase, wouldn’t this lend itself towards the underlying “obligation” being treated as debt, with any payment made by buyer to seller prior to the exercise (or lapse) of the option being for the forbearance of money (as opposed to allowance for lot price appreciation)?

In Koch, the end result was no immediate taxation on the option money received. The theory was that it represented part of the purchase price, not to be recognized until the “transaction” was closed (even though the option money, technically, wasn’t to be applied to the purchase price). The judge basically said the option money was to compensate for expected price appreciation. I realize Koch may not have been dealing with inventory. But if we are saying Koch is distinguishable, because the purchase was contractually agreed to in OP’s case but not in Koch’s case, wouldn’t that imply that the option money in OP’s case isn’t consideration for the property itself, like in Koch, but instead, is for the forbearance of money?
 

#9
Chay  
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Jeff-Ohio wrote:As to your second sentence, that’s kind of what I was getting at with my Post #3. But Post #5 seems to reveal that it’s a true option arrangement.

In Koch, an option arrangement is distinguished from a purchase contract in that "the optionor becomes entitled to keep only the amount paid as consideration for granting the option (the tax consequences being controlled by section 1234) and has no enforceable right of action against the optionee for damages". Post #5 may point in this direction, but I think we also need confirmation of this additional point.

But if it really is a “contractually agreed to” purchase, wouldn’t this lend itself towards the underlying “obligation” being treated as debt, with any payment made by buyer to seller prior to the exercise (or lapse) of the option being for the forbearance of money (as opposed to allowance for lot price appreciation)?

If you want to book a credit the buyer's liabilities, then where does the debit go? There is no actual transfer of property until the payments are made. That speaks more strongly to me of a single transaction consisting of a credit to cash and a debit to land.

But if we are saying Koch is distinguishable, because the purchase was contractually agreed to in OP’s case but not in Koch’s case, wouldn’t that imply that the option money in OP’s case isn’t consideration for the property itself, like in Koch, but instead, is for the forbearance of money?

If I enter into a contract to buy your car from you a year from now, but in the meantime you have full rights to the use and enjoyment of the car, do you need to recognize some of the sales proceeds as interest income a year from now? Does anything change if I make a partial payment when the contract is signed?
 

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If you want to book a credit the buyer's liabilities, then where does the debit go?


I wasn’t really looking at it that way, from an accounting perspective. I was more thinking about it in this way: I was accepting your proposition that OP’s situation is distinguishable from Koch (i.e. the purchase has been contractually agreed to). But maybe you need to explain yourself further there. I was basically thinking that if OP’s case is distinguishable from Koch’s on that front, then maybe the result in Koch wouldn’t be the same result in OP’s case.

I’m more or less trying to figure out if there is a valid reason for the Big Firm’s tax treatment of these options payments. On it’s face, Koch seems applicable and pretty strong to me. But again, Chay says it’s distinguishable. He says in Koch, the option created a right to purchase, freely exercisable by the purchasing party. But isn’t that the case in OP’s fact pattern?
 

#11
Chay  
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The key to all of this is going to be whether the client has an "enforceable right of action" against the purchaser for anything besides the option fee if the purchaser doesn't follow though. If there is no such right, then my proposition fails and OP's facts are in line with Koch.

But to your point, I don't think there's a valid reason for Big Firm's tax treatment under either scenario.

If there is an enforceable right of action, then we have a traditional sales arrangement and all gross receipts should be split between interest, gain and return of capital. Because the title hasn't changed hands yet, I fail to see where the seller has become a creditor, and I wouldn't include any interest until some property is actually conveyed. If the price of that property is covered in full when it's conveyed, there still wouldn't be any interest.

If there is no enforceable right of action, then we have a Koch situation and the nature of the option payment is uncertain. It would represent pure income for options that aren't exercised and it would represent a mix of gain and return of capital for options that are exercised.

Taking the whole thing and throwing it into interest income just sounds like something a lazy junior accountant who saw the term "Land Bank" would do.
 

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Taking the whole thing and throwing it into interest income just sounds like something a lazy junior accountant who saw the term "Land Bank" would do.


Maybe so. And if he did that, seems the timing might not be right either…

But to your point, I don't think there's a valid reason for Big Firm's tax treatment under either scenario.

You’re probably right. I’m thinking that if we batted this around enough, OP would have a higher degree of comfort/confidence when (and if) he talks to the folks at Big Firm about their treatment. They, of course, would have to have a compelling reason why they are treating this thing as if an enforceable debt exists. I’d be interested to see what comes out of that conversation. And if I was the OP, I would have that conversation. I think it will add some confirmation/clarity to the situation, instead of just assuming Big Firm is wrong.

If there is no such right, then my proposition fails and OP's facts are in line with Koch.


I tend to think there is no such right and that what we have here is a real option agreement…and if the value of the lots go kerplunk, while held by OP’s Land Bank client, that client bears that full risk (only to be mitigated, of course, by the option payments it received), with no right of action.
 

#13
Dennis2  
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essentially the fund acting as the lender for land investments


"Option Fee" on the capital balance outstanding (12 - 15%),


Be nice to know (and easily computed) the effective interest rate the total options collected represent over the life of the takedown schedule. Also nice to know about things like insurance and real estate taxes. Also nice to know historical default rate.

[quote][/The land is only held for a year or 2 and lot tracts start being sold within a few months of closing. quote]

Also nice to know actual average effective interest rate based on historical data.

May be enough language here to maintain ordinary income but personally I prefer the conservative approach of the large firm.

Is there for example, any business reason for the option language other than an attempt to get a certain tax treatment?
 

#14
Dennis2  
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or, from the developer's point of view, a better looking balance sheet?
 

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Interesting points by Dennis.

Chay also asked this:

If I enter into a contract to buy your car from you a year from now, but in the meantime you have full rights to the use and enjoyment of the car, do you need to recognize some of the sales proceeds as interest income a year from now?

Of course, a car involves usage. Raw land, that is subject to an option, can’t be developed during the option period. The land owner can’t really do anything to or for it, except hope it increases in value (or at least maintains its value). Land is also an appreciating asset, especially if surrounding lots will be developed, unlike a car. Those points aside, to liken the car to OP’s land, we’d have to interject an option agreement and an option payment. And if we do that, let’s take the general premise of Koch: Guy buys land for $50k. Option agreement is set and a $5k option payment is made. Purchase price is set at original $50k cost. The option payment will not be applied to the purchase price. Option is exercised and land is sold. Journal entry to record the sale would be (1) debit to cash $50k (2) debit option liability for $5k (3) credit sales proceeds for $55k. Koch says to do this even though, per the agreement, the option payment wasn’t to be applied to the purchase. The judge basically said that, despite the agreement, the full $5k is a measure to account for price appreciation. But to answer Chay’s question, why isn’t possible that we up the purchase price by only $3k, say, with the other $2k of the option payment representing interest? In other words, only a portion of the $5k is a measure to price appreciation (and/or to insulate the original buyer against price depreciation…which is a risk that comes about from the option agreement since the buyer cannot sell the property to anyone else during the option period)…and the rest is for the forbearance of money?

But quite honestly, I think all of this is neither here nor there, since it is a dissection of something that would be cast as a sale up front. If there is no sale up front, there is no indebtedness up front. As Chay says, you can’t make a one-sided journal entry, which means you can’t make a journal entry at all.

The question then becomes if you can have interest when a transaction doesn’t involved indebtedness. There is no doubt that in an option transaction, even if it’s not exercised, an element of interest could be at play. But it seems that would involve a massive splitting of hairs. How are we to figure out how much is compensate for expected price appreciation (non-interest)? How much is to offset price depreciation and holding period risk, which would involve the lapse of the option (non-interest)? And how much might actually represent a payment for the forbearance of money? It seems impossible to do, unless we start with the interest piece, based on a market rate, and then back into the other things. Koch would tell us that these gymnastics are misplaced. If there is no actual indebtedness, but a true option agreement, there is no interest.

I do think that if true related parties were involved, with a pre-arranged plan, it’s possible that a “no true indebtedness” situation could be viewed as a lending transaction. After all, if true related parties are involved, the same folks are bearing all the risk, no matter how the transaction is structured.

But what if we had parties that only had a business relationship, say a developer who always used the same Land Bank? It’s possible that the Land Bank might say, “Hey developer, we’re acting as a lender to you. Give us a 5% interest rate plus a kicker in case the price drops and you don’t exercise.” It seems that Koch would take us back to the idea that there is still no real indebtedness…
 

#16
dave829  
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TPAtaxCPA wrote:It is a little different because the land is actually never sold at a gain

Yes, it is. The Land Bank buys the land and charges an option fee to the home builder. The home builder is paying the option fee in order to reserve the right to buy the lots at the Land Bank’s cost, so the price is “locked in,” which is a typical option arrangement for real estate. The option fee is certainly part of the sales transaction.
 

#17
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Developer buys land for 900K, puts 100K into subdivision and related costs, sells to land bank for 1 mil,
cuts a check to land bank for 120K in return for an option to repurchase in pieces totaling 1 mil.

And this convolution is substantially economically different than a non recourse loan with prepaid
interest and an irregular payment schedule?
 

#18
Chay  
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Dennis2 wrote:And this convolution is substantially economically different than a non recourse loan with prepaid interest and an irregular payment schedule?

Yes, it's quite obviously different.

With a loan or a loan-like situation such as an installment sale, the debtor is on the hook to pay up or else the creditor can take legal action to enforce his right to receive the agreed-upon money. In the case of a non-recourse loan, the legal action is limited, but it's still legal action. The creditor is seizing something that belongs to the debtor.

With an option, all that happens if the option isn't exercised is the optioner takes the option fee into income and is relieved of the obligation to sell the property to the optionee. No one is suing anyone or seizing anything. The property was always owned by the optioner and will continue to be so owned.

If the OP's facts are clarified to be in the nature of a true option arrangement, that will result in no debtor-creditor relationship and thus no interest income notwithstanding the term "land bank". If it turns out there is a more substantial obligation on the purchasing party, that could result in a situation where interest income is recognized by the land bank, but not until there is some kind of credit that has been extended in the form of money or property.
 

#19
Dennis2  
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Nonsense. the only legal action that can be taken on a non recourse loan is foreclosure. how is that different in substance from the result on default? In either case than land bank is stuck with the identical asset.
 

#20
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On the surface, it certainly does seem like it’s a lending arrangement. However, like in Koch, there is no true/labeled/legal indebtedness. The paperwork reveals that truth. But is that factor, the label, determinative?


There are other examples where the substance of a transaction is a financing even though its legal form is something else. Lease-purchase, rent-to-buy, lease with $1 purchase option at the end, land contract, whatever. The legal title stays with the lender, lessor, retailer, seller, etc., making it way easier to re-sell the property w/o having to go through legal foreclosure or repossession.

So, as has been stated above, for there to be interest income, there has to be debt. To me that means there has to be (in substance, for tax purposes) either a sale of the land by the land bank on terms that require payment later, or a loan by the land bank, with proceeds used by the developer to buy the land. OP's facts seem to me to be way more like a loan with the land bank holding title as security and restricting development until payment is made for specific lots. The 12-15% up front "option fee" compensates the land bank for their cost of money plus the risk of having to sell the land again to recover their investment.

I may have missed it, but how does the developer report these deals?
 

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